According to the received wisdom, innovation is the heart-and-soul of modern growth but incentives to innovate are prone to the free-rider problem. This column partly supports that view. Looking at over 1,000 US companies it shows that internal citations of a firm's patents have a positive effect on market value while external citations have a negative effect.

Knowledge spillovers play a critical role in economic growth. For example, x-ray-computed tomography technology was developed and patented by EMI, which was able to exploit it initially. However, it also inspired hundreds of subsequent inventions by firms such as Pfizer, Syntex, Picker, and General Electric. A few years later these firms dominated the computed tomography scanner market, forcing EMI to drop out.

The spillovers generated by the original EMI invention were mostly external to EMI, meaning that those spillovers were not useful to EMI. While EMI was responsible for the creation of one of the most influential medical inventions of the 20th century, it lacked the capability needed follow up its invention with outside discoveries and remain at the technology frontier.

This raises an important question: do firms whose inventions result primarily in external knowledge spillovers have a lower stock market value than firms whose inventions result in more internal knowledge spillovers?

Theory and evidence point to positive and negative ramifications for spillovers. On the one hand, spillovers encourage innovation by providing the basis for future research. On the other hand, firms don’t want to spawn research that may ultimately undermine their market position or render their own research obsolete. The prospect of future research undermines the process of knowledge creation in the first place.

In a seminal paper, Aghion and Howitt (1992) argue that this effect can be so large as to create a “no-growth” trap where the incentives of early inventors to invest in R&D completely disappear. However, little work has been done to examine whether this negative effect of spillovers may be mitigated. If the inventing firm could reabsorb its spilled knowledge in a future period together with subsequent developments made by other inventors, it might be able to escape the no-growth trap and sustain its long-term returns.

If knowledge frequently 'spills' outside the boundaries of the inventing firm, it is important to understand if and how it can feed back and interact with the originating firm’s internal R&D. In a recent paper (Belenzon 2012), I develop a new construct of knowledge recombination in the context of sequential innovation, conceptualising new combinations of knowledge as the ability of a firm to combine its past inventions with follow-up external developments.

Differences in the ability of firms to creatively reuse their own knowledge with external ideas explain a large part of the cross-firm differences in the value of intangible assets. Using patent and citation data, I propose a new way of measuring the re-absorption of 'spilled' knowledge by inventing firms. I distinguish between two types of citations from outside inventors: internal and external. Internal citations are made by patents connected to the firm.

An example would be Microsoft citing a 2010 Intel patent that cites a 2008 Microsoft patent. In this example, Intel's follow-up development of the original Microsoft patent is internalised by Microsoft in its later invention. External citations, by contrast, are those that do not feed back into the original inventor's research programme in any subsequent period.

Previous research has mostly focused on how private profits from innovation can be shared contractually between early inventors and their followers. The consensus is that explicit agreements between the first and second innovator can be beneficial, because they compensate the early innovator for their losses due to shorter patent life. However, designing and enforcing contracts that would allow enough transfer of profits while mitigating incentive conflicts is a very difficult task. Coordination costs, overlapping patent claims ('thickets') and hold-up problems are some of those issues.

This difficulty emphasises the need to deepen our understanding of how private rents can be captured by rent-seeking enterprises, especially when inventions are highly dependent on one another. By combining past firm-specific knowledge with outside follow-up developments, the firm can potentially not only mitigate loss of profits by offering new products, but also to capitalise on R&D complementarities between its past research efforts and relevant outside developments.

In economics, the number of times a patent is cited provides useful information about its importance. Citations are also used to measure knowledge spillovers. Both patent quality and knowledge spillover aspects of citations can help determine the inventing firm’s profits, as well as shed light on the relationship between innovation and firm value. I use information on patent citations to learn about subsequent developments of knowledge because patent citations are a legal instrument used to determine the scope of patent protection.

The inventor identifies prior projects that are technically related to the patent application. If patent B cites patent A, that indicates that patent A contains a piece of knowledge on which patent B builds. (Clearly, this piece of knowledge is excluded from the scope of patent B.) The citations allow me to construct sequences of patents that cite each other, which are then analysed to classify patents along the sequence as internal, external, or self-citations.

Using data on about 1,200 US patenting firms between 1981 and 1997, I find a strong, positive relationship between measures of knowledge recombination and stock market value. Specifically, I find a positive relationship between market value and internal citations, and a negative relationship between market value and external citations. Increasing the share of internal citations by the sample average and assuming that the change comes from having fewer external citations is associated with an increase in $70 million in market value.

Moving from the 10th to the 90th percentile in share of internal citations is associated with an increase of about 10% of firms' average value. As one would expect, I find a stronger relationship between value and citations in more cumulative, rather than discrete, technology areas (for example, telecommunications versus drugs). Internalisation is less likely to be effective in industries where inventions are more dependent on one another. In such industries reapplying knowledge has a stronger effect on value.

My findings lend strong support to the view that re-incorporating spilled knowledge can result in higher value for firms, and call for further research to better understand strategies that firms can adopt to actively engage in such recombination.